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Many people struggle with whether brands and suppliers should be setting their pricing based on a variety of factors, from cost, to value, to product differentiation. Here we will explore some of the methods of price setting and their relative benefits.
I recently wrote a post on the power of premiumisation since then I’ve had a lot of people sharing some of their challenges and a common theme was, “we’ve got a great premium product but we don’t know how much extra we can charge for it?”
In this article I’m going to outline two approaches and why we believe one is superior to the other. Incidentally the proposed approach can be used to price any new product.
The not so good option - cost plus
Cost plus is where you look at the additional cost of your premium product and charge the consumer for that differential (plus a mark-up). So if the additional cost is $0.50 per unit then you’d charge the consumer an extra $0.50 per unit plus a mark-up. Whilst it appears simple there are some challenges:
You often don’t know your final cost until quite late on, there are final contracts to be negotiated, new manufacturing processes to be established, new packaging costs etc. This can make it largely guess work and can cause the price to move around as you develop the new product.
This approach will protect your margins, but the whole idea of premiumisation is to enhance margins not just to stand still.
With a healthy markup on the cost you can use it enhance your margins, but how much markup should you use? At this point it becomes pure algebra, pick a margin you want to hit then work out the required markup, you’ve no idea if consumers will pay it or even if you could have charged more?
Fundamentally you are starting from the wrong position, consumers will usually have very little idea of what the additional cost is so will not be making a decision based on whether they think they are getting good value for money.
Take a product that has been aged for an extra 12 years in aged oak barrels. How many consumers will work out the discounted cash flow of the extra investment from 12 years of storage and fine oak barrels? and then add that on top of the regular product?
Or an ice cream made with finest Madagascan vanilla, how many consumers are really going to research the additional cost per KG of the Madagascan vanilla vs the standard product?
Using the incremental cost as a basis could actually massively underprice your product as consumers perception of the additional cost may be much higher than reality.
This is usually where finance directors will turn pale and stress the importance of ensuring NPD doesn’t dilute their margins, and of course it mustn’t, one of the first things you should do when working on NPD is work out what you can sell it for and ensure that you can then make it at a cost that enhances your margin, this doesn’t however mean that you use that cost to set a price…
The better option - value based pricing
Value based pricing is where you set a price based on what you can charge a specific segment of consumers for the differences of your product vs the next best alternative. The graphic below illustrates this:
Firstly you need to identify your specific segment of consumers, in the example above given you are adding Vitamin C to the product you may choose to look at consumers of the original product who are more health conscious, equally the consumer segment could be consumers who don’t currently buy the original product but the addition of Vitamin C may get them to buy the new product. You may end up with a shortlist of several different consumer segments, this is fine, you should rank them on what you believe are the most relevant and likely consumers of your new product.
Secondly you need to establish how much extra you can charge your consumer segment for the differences in you new product, you do this by asking them…. You can of course literally get them in a room and ask them, but a more mathematical approach is to conduct some conjoint analysis. Conjoint analysis is where you survey your chosen consumer segment asking them “which would you buy?” when presented with different combinations of product features (e.g. with Vitamin C / without) at different price levels etc. If you ask enough of these questions to enough people in your chosen segment, you can mathematically establish how much you can charge for your new product to ensure you are maximising the likely demand.
Historically conjoint analysis was a significant undertaking but with as with so many other things today the maths & methodology are readily available with a multitude of relatively inexpensive online solutions, the biggest challenge is segmenting and recruiting respondents.
Now you’ve got your price you can work internally to make sure the margins you are going to make are sustainable and hopefully incremental.
So what are the benefits?
Starting with an understanding of what the consumer will pay means you are not leaving any value on the table i.e. not under / over pricing
The price you end up with has been validated vs a product already in the market giving you a higher level of confidence that you can achieve that price in market
The analysis you do to establish a price will also give you an indication of likely demand for your product and which consumer segments you should target with your marketing
The exercise can be done very early on in the development, you don’t need final pack designs or final product formulations so you can quickly establish the financial feasibility for a new product
The key highlight in the approach outlined above is to always start with the consumer, how much are they going to pay for your new product, then work backwards in terms of how much you can make it for and whether that can give you and your customer sufficient margins to make the product a feasible offering. The other key point is the earlier you do this the better, we’ve all been in NPD scenarios where the product has been in development for a number of months / years and people have got very attached to their “baby”, only to find out late down the path that the financials don’t stack up.This can cause a lot of political headaches / damanged egos and holes in the plan where the NPD was meant to be a big growth driver.